How Useful Were Recent Financial Innovations? There Is Reason To Be Skeptical

Who could be against innovation? That is the argument used by industries that wish to avoid regulation, that excessive government oversight will diminish incentives to innovate, or erode property rights to innovations, and we all will be worse off for it. And in the broad, this is a valid concern. We are all better off for having had new products and even paradigms in pharmaceuticals, in aerospace, in energy (we hope soon), and, yes, in financial services. We should not kill the geese that lay the golden eggs leading to ongoing productivity growth.

But not every innovative product is safe, let alone productive. Unlike pharmaceuticals, aerospace, and a host of other technical fields, financial innovations have been allowed to proliferate unscrutinized and untested for safety or effectiveness. Yet the negative spillovers on the public at large from faulty financial engineering and toxic products have now been clearly demonstrated to be enormous. In particular, there is some solid evidence that the most recent batch of financial innovations was used in manners inconsistent with their labeling, and not only had terrible side effects, but did not even yield the advertised benefits.

Like most innovations, the theory behind the most-recent financial developments made sense. Innovative financial products such as credit default swaps and collateralized debt obligations were supposed to promote an efficient allocation of risk and hence allow those market participants to bear the risk of an asset who could do so best. Freed from the burden of such risk, nonfinancial companies would be able to engage in more-productive capital formation, generating growth for the entire economy. Furthermore, financial companies would be more stable because they would be able to get illiquid assets off balance sheets and not be tied to collateral.1 This mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country's capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

Source: Bank for International Settlements (BIS), International Financial Statistics, via Datastream (IFS) Office of the Comptroller of the Currency (OCC)

The growth of derivatives and real-sector investment in the United States tell a different story (figure 1). Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin. This has been especially true since 2006, when investment stagnated, but derivatives continued to grow at a rapid rate. There only seems to be a weak link, if any, between the growth of the newest complex—and now proven dangerous if not toxic—financial products and real corporate investment.

Another way to assess the presumptive benefits for the real economy of these products is to analyze who made use of derivative instruments. Figure 2 shows the share of OTC derivatives by counterparty as of June 2008 (78 percent of all global derivatives for which such a level of detail is available are included). Reporting dealers, mainly banks and investment banks, accounted for 41 percent of all counterparties (double-counting is eliminated). Other financial institutions acted as counterparties in almost half of all cases. Only 11 percent of all counterparties were nonfinancial costumers. Hence, almost 90 percent of all derivative contracts took place between financial institutions. Had their usage by financial institutions generated either a boom in productive lending or a more resilient financial system, then, even if unused by nonfinancial companies directly, these new products could still have been productive. Since we have clearly seen the opposite over this time period, it is a revealing indicator that the nonfinancial companies for whom these products were prescribed did not themselves use them.

Figure 2 OTC derivatives by counterparty as of June 2008 (BIS)

Source: Bank for International Settlements (BIS)

Going forward, the US Congress and its international counterparts will have to decide how much to increase regulation and supervisory oversight of financial institutions. We are already hearing warnings from the financial industry that government should be careful not to overreach in its attempts at reform, for fear of harming financial innovation. While that is a worthy principle, our belief is that the record of recent financial innovations acts as a warning to be skeptical about excessive claims that all financial innovation is worthwhile. What was advertised as something to redistribute risk, and thereby increase productive investment, generated little capital formation; what was supposed to benefit nonfinancial businesses was mostly used in a speculative game between financial players. In fact, given the gap between these products' claims and their actual usage and impact, one has to wonder whether recent financial products are like the recalled weight-loss supplement Hydroxycut, the repeatedly crashing DC-10 aircraft, or the Chernobyl nuclear reactor design. If so, even if many financial innovations are beneficial, all of them need to be monitored over the long term, as well as scrutinized before issuance, by regulators for their safety and effectiveness.